The Netflix Story Is Still in the First Act

 | Dec 01, 2011 | 2:00 PM EST
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One maxim followed by many value-oriented investors says that the best opportunities to score outsized gains require investing during periods of maximum pessimism. Market pessimism is a value investor's friend because the opportunity to buy a quality stock at a favorable price is amplified when the asset in question is loathed by the market.

Netflix (NFLX) shares may be a textbook case of that pessimism at work. Just over two months ago, the media-delivery service's shares  climbed past $300, putting its market cap at more than $16 billion. Investors and analysts alike were happy to praise Netflix at those valuations, even though the company was trading at more than 70x earnings and free cash flow. But after a widely publicized miscue -- an attempt to split the DVD and streaming services into separate plans -- by CEO Reed Hastings, shares plunged as the company lost subscribers in the third quarter ending September 2011.

Netflix shares have come back to Earth, trading around $64 with a market cap of $3.3 billion. At that price, the company trades for around 12x average free cash flow over the past three years. While third quarter results were solid, investors reacted swiftly and mercilessly to a loss of 800,000 net subscriber during the quarter. Furthermore, the company said it expects continued subscriber loss from its DVD segment in coming months. Bothered by the uncertainty the company faces in coming months, investors staged a mass exodus.

As overly optimistic as Mr. Market was when he sent shares above $300, it's quite likely that today's pessimism is exaggerated and that Netflix shares could produce a windfall for investors over the next couple of years.

The company's model is not broken. Netflix is a low-cost provider, period. For $7.99 a month, less than it costs for one person to eat lunch at Chipotle (CMG), an entire family can get unlimited access to tens of thousands of movies and TV shows instantly. You'll pay up to $6 to watch one On-Demand movie from Charter Communications (CHTR) or Comcast (CMCSA) for 24 hours. That seems like an outright steal to me.

Netflix has found a way to distribute content at an incredibly low price. It is the future of content distribution, not the past. By nature, consumers always overreact to higher prices. Subscribers who left because $16 a month for access to streaming and DVD by mail was too expensive were probably not going to stay anyway, so the subscriber loss was already baked in. My guess is if Netflix had lost those 800,000 over the course of a year vs. one quarter, the share price would not have been so volatile.

With people still paying between $60 and $100 a month for cable programming alone, I would argue that Netflix has some degree of pricing power, especially as its library of titles expands. It is a concern that the company will likely have to pay more for content, but Netflix has built a business model that will continue to grow and add users over time. This is not the first hiccup the company has had to overcome. As the company's growth came under fire during the recession, shares fell as low as $20 before surging to $300.

Netflix will likely get it right again. At the current share price, incredible upside awaits those investors who realize that this growth story is still in its first act.

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